Banking on Quicksand

U.K. banks are sitting on a $38 billion hole, according to the Bank of England. The regulator announced the shortfall today but did not say which banks were looking thin. The move to shore up reserves is driven by the fear of weakness in the European economy and a need for banks to hit the capital requirements of Basel III. By 2018, banks will need to meet a 7% capital ratio, and recent crackdowns have made that a harder target for banks to hit.

While not every bank is in dire need, the consensus is that both RBS (NYSE: RBS) and Lloyds (NYSE: LYG) are going to need to go back to the table. HSBC reportedly has one of the largest capital ratios, which was bolstered earlier this year when the company closed the sale of its Ping An holding. In the middle sits Barclays (NYSE: BCS) , which has gone on record to say that it will work through 2013 to improve its capital position.

As the deadline for capital requirements approaches, investors need to watch out for banks that fall short. Raising capital will mean selling off valuable assets, diluting shareholder earnings through new offerings, or cutting back on dividends to retain extra capital.

Loops get closedEarlier this month, the Basel Committee announced that it was going to treat insured risk differently, making it harder for banks to boost their capital by simply insuring against default. Up to this point, banks had been able to purchase protection for their risky assets, in effect making them less risky. While the premise is sound -- and not nearly as close to the rererereinsured mortgage portfolios of 2008 as one might think -- banks were abusing the practice. Shocker.

The problem was that banks could buy the insurance, but spread their premiums out over a long timeframe. That meant banks profited immediately on their capital requirements, but didn't take on the risk of having to pay off the insurance for years. That deferral of risk is one of the things that central banks and regulators have been trying to fight, and Basel decided to crack down on the system.

To this point, banks from Citigroup to Goldman Sachs had been reportedly engaging in the practice to help their balance sheets. While those firms will still be able to insure their risk and add to their capital, they must now recognize the costs associated with that insurance upfront.

Sticky wicketI know it's not really like a sticky wicket, but come on. Banks in the U.K. have been fighting to meet these new requirements since their inception. Lloyds is now reported to need about 2.5 billion pounds in order to meet its goal, and the bank has begun selling off some of its holdings to increase its funds. Lloyds came under new public scrutiny this week when the bank confirmed that 25 of its employees had been paid over 1 million pounds in 2012. The drivers of the outcry are three. First, the U.K. government still owns a big chunk of the bank. Second, it made a 570 million-pound loss in 2012. Finally, the bank needs the capital.

While the setback is minor -- under 50 million pounds in huge bonuses compared to the 2.5 billion pounds it reportedly needs -- the message it sends is huge. Compounding the effect are big bonuses being paid across the rest of the U.K. banking sector, with Barclays reportedly doling out 428 1 million-pound-plus bonuses and RBS issuing 95 such payments. The outrage at the big paydays is fueled by these shortfalls. The British public sees the bonuses as undue reward for banks that have yet to succeed.

Investor bewareClearly, some companies are better off than others. HSBC's capital position has been helped by its larger-than-average exposure to Asia, where profits have been more consistent. Barclays dipped into the pockets of private investors during the crash and avoided the government oversight and missteps that have plagued RBS and Lloyds. Investors need to do some digging before making any big moves in the banks.

Even the biggest banks may find themselves low on cash if LIBOR-related litigation continues to pile up. HSBC has also faced fines related to money laundering, and the Ping An sale shows that management isn't completely satisfied with the capital on hand. Investors would do well to remember that it's a long way to the official deadline for Basel III at the end of 2018, and a lot can happen between now and then.

With big finance firms still trading at deep discounts to their historic norms, investors everywhere are wondering if this is the new normal, or if finance stocks are a screaming buy today. The answer depends on the company, so to help figure out whether Goldman Sachs is a buy today, I invite you to read our premium research report on the company today. Click here now for instant access!

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